Using liability-driven investing to derisk corporate pension plans

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1 EATON VANCE NOVEMBER 2015 TIMELY THINKING Using liability-driven investing to derisk corporate pension plans SUMMARY Defined benefit (DB) pension funding ratios remain near decade lows. Underfunded pension plans may force firms to John Croft, CFA Portfolio Manager, Credit Analyst Stacey Starner McAllister, CFA Team Leader, Senior Diversified Fixed Income Credit Analyst allocate resources away from everyday operations and capital investments. A liability-driven investment strategy that matches plan assets to plan liabilities can help minimize funding gap volatility.

2 NOVEMBER 2015 TIMELY THINKING LIABILITY-DRIVEN INVESTING 2 For private corporations sponsoring DB plans, managing risk is a constant challenge. Specifically, funding ratio volatility can cause significant problems to plan sponsor balance sheets. The chart below shows average funding ratios for the largest DB plans since the turn of the century. The surplus many sponsors enjoyed in 2000 has been replaced by deficits as interest rates have declined and capital markets have been rocked by two major recessions. Even in recent years, with considerable improvement in risk asset returns, funding ratios have remained near decade lows. Funding gaps can lead to a number of problems, including lower credit ratings, higher Pension Benefit Guaranty Corporation (PBGC) insurance premiums and the need to make large cash contributions to the plan. Additionally, an underfunded pension plan may force firms to steer resources away from everyday operations and capital investments and toward reducing the obligation associated with the plan. Due to all of these issues, plan sponsors have been increasingly derisking their pension plan investment strategies. One way to do this is by considering a strategy that matches plan assets to plan liabilities, thereby minimizing funding gap volatility. A recent Pyramis survey 1 of the largest corporate pension plans labeled this type of liability-driven, or LDI, investment strategy as fully mainstream. Pyramis noted that 47% of U.S. corporate respondents were using LDI as of November 2014, up from only 31% in Here at Eaton Vance, we agree that derisking a pension plan s portfolio is advisable for many plan sponsors. We further suggest that a custom LDI strategy, which is specifically constructed to match the movement of a particular plan s assets to its liabilities, is often the best tool for derisking. Exhibit A Pension funding ratios remain near decade lows Milliman 100 Pension Funding Index Ratio Percent (%) '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 Source: Milliman 2015 Pension Funding Study, April The Milliman 100 companies are the 100 U.S. public companies with the largest defined benefit pension plan assets for which a 2014 annual report was released by March 5, The Milliman 100 Pension Funding Index reflects the effect of market returns and interest-rate changes on pension funded status. It is not possible to invest directly in an index Pyramis Global Advisors Institutional Investor Survey.

3 NOVEMBER 2015 TIMELY THINKING LIABILITY-DRIVEN INVESTING 3 What are some derisking options available to plan sponsors? There are multiple solutions available to address the funding ratio volatility concerns of plan sponsors. Each solution has its own costs and considerations that you need to be aware of when making a decision on what s appropriate for your plan. We have highlighted a few of these options. Lump sum/termination Terminating a pension plan via a lump sum can be an ideal solution, but comes at a considerable cost to the plan sponsor. The plan needs to be at least 80% funded to entertain this option and typically requires a contribution that brings the funded status to between 105%-115% depending on the actuarial characteristics of the plan. Annuity purchase/buy-in/buyout Buy-in and buyout strategies involve a transfer of the liabilities of the plan to an insurance company who takes responsibility for annuity payments to participants. This may allow the plan sponsor to remove the obligation from the balance sheet, but generally requires a contribution that brings the funded status of the plan to around 110% in order to enter into this type of arrangement. In 2012, General Motors (GM) made news after it transferred $26 billion of its $134 billion total pension obligation to Prudential. Prudential required GM to contribute $29 billion in assets to assume this $26 billion obligation on behalf of GM. 2 Liability matching Liability matching entails designing a custom fixed-income portfolio that generates cash flows in the form of principal and coupon payments that match the participant benefit payments that are required by the plan. This approach is usually combined with a predetermined contribution plan that seeks to close the funding gap for the plan and transition a larger percentage of assets to the liability-matched portfolio. What is LDI and why is it a compelling strategy for plan sponsors? The two common themes that you notice with the lump sum/termination and annuity purchase/buy-in/buyout options are the fact that they require a significant capital contribution based on current funded ratios. The firms that have pursued the annuity purchase option are generally heavily capitalized companies such as GM, Ford and Verizon. Many other small and midsize companies don t have access to the cash or the low-cost financing that is required to make this a viable strategy. We feel a liability-matching approach is a much more financially feasible option for many plan sponsors. This approach offers the opportunity to lower funding ratio volatility on a portion of the plan s assets, while implementing a contribution plan that seeks to eliminate the funding gap over time. Many plan sponsors design an asset allocation for their DB plan that is focused on closing the funding gap by investing in equities and other risk asset classes such as high-yield bonds. However, managing the funding gap requires that valuation changes in both the assets and the liabilities be considered. As we saw in 2014, risk assets generally had positive returns, but due to interest-rate moves, liability values rose much more than investment portfolios, leading to a significant drop in funding ratios. At the very least we recommend that plan sponsors consider and understand the funding gap risks that they are taking. 2 Vlasic, Bill and Walsh, Mary Willams. G.M. Plans Big Buyouts for Retirees in Pension, The New York Times, June 1, 2012.

4 NOVEMBER 2015 TIMELY THINKING LIABILITY-DRIVEN INVESTING 4 At the same time that plan sponsors are investing in risk assets in order to generate returns, we also find that they generally have some meaningful allocation to investment-grade fixed income. Often, managers assume that any investment-grade exposure is the low-risk option for a pension plan. While investment-grade fixed income would certainly be lower risk than some other asset classes, the portfolio must be constructed in a way that matches the risk exposures of the plan s liabilities in order to truly reduce risk. A mismatched portfolio is likely to introduce new risks and at the same time produce less income than a fully matched portfolio. For example, fixed-income investments benchmarked against the Barclays U.S. Aggregate Bond Index (Barclays Agg) are a common component in many pension portfolios. Pension liabilities, however, generally have significantly different characteristics than this common index. Exhibit B shows interest-rate exposures at each point on the yield curve (key rate durations) for the Barclays Index (light blue) versus those of a typical pension liability (dark blue). Overall, the effective duration of the Barclays Agg is 6.6 versus 14.6 for the liability, and this longer duration is concentrated in a few of the longer key rate buckets as shown in Exhibit B. Clearly the Barclays Agg and the pension liability have far different interest-rate sensitivities. This is generally true of any fixed-income index not specifically designated for pensions, as the maturity profile of the universe of available investment-grade bonds is vastly different from that of pension plan benefit payments. In addition, the Barclays Agg has several other exposures that differ markedly from a pension liability. Exhibit C on the following page points out the considerable asset class risks that investing pension assets in the Barclays Agg creates. Often, we see pensions investing in managed funds benchmarked to the Barlcay s Agg or similar indexes, having additional, and often surprising, asset class exposures. Exhibit B Is investment-grade exposure a low-risk option for pension funds? Pension liability vs Barclays Agg: Duration comparison 4 3 Duration m 1yr 2yr 3yr 4yr 5yr 6yr 7yr 8yr 9yr 10yr 15yr 20yr 25yr 30yr Key rates Pension Liability Barclays Agg Sources: Barclays, Bloomberg. Barclays U.S. Aggregate Bond Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities. It is not possible to invest directly in an index.

5 NOVEMBER 2015 TIMELY THINKING LIABILITY-DRIVEN INVESTING 5 What approach does Eaton Vance take to LDI? Eaton Vance takes a fully customized approach to LDI, where we start with the plan s specific benefit payment profile and its particular discount rate and then create a portfolio that very closely mirrors the risk profile of the pension liability. The goal of the strategy is to create the lowest risk portfolio from the perspective of the funding ratio. We are able to do this at pricing and asset minimums that generally rival a less customized mutual fund or ETF-based solution, with far more precision. This strategy ensures that assets are continually managed with the client s specific liability in mind, rather than the benchmark-based focus of other approaches. We are committed to working closely with our clients to successfully implement this liability-matching strategy. We provide a collaborative approach to small, midsize and large DB plans, working closely with the consultant and the client to design the appropriate fixed-income portfolio to meet their needs. In addition to offering a portfolio that seeks to minimize variance with the liability, we can work with clients to analyze and tailor risks to suit their particular situation and strategy. Exhibit C Asset class risks of the Barclays Agg Pension liability vs Barclays Agg: Asset class exposures C Market value % difference % Governments 9.1% Agencies -74.9% Corporates 29.7% Mortgages Sources: Barclays, Bloomberg. Sectors as determined by Bank of America/Merrill Lynch. It is not possible to invest directly in an index.

6 NOVEMBER 2015 TIMELY THINKING LIABILITY-DRIVEN INVESTING 6 Conclusion It is important to understand the risks that DB plan sponsors face and the strategies available to help manage those risks. DB plans continue to be a complex risk for companies to manage, and they have material effects on the financial statements and operational flexibility of sponsor firms. Utilizing a custom liability-matching portfolio to decrease funding ratio volatility may create a path to eliminating the pension liability risk from the balance sheet. Eaton Vance remains committed to helping plan sponsors and consultants address these challenges to create successful outcomes for the future of these DB plans. Our Defined Benefit Solutions Team, led by portfolio manager John Croft, CFA, works closely with all parties to gather the appropriate plan data, offers analytic support for plan sponsors considering their pension strategy and creates a custom solution reflecting the client s exact situation. Being a customized portfolio, the consultant and plan sponsor have the ability to tailor their portfolio s characteristics to their individual circumstances, and those characteristics can also be changed at will. The end portfolio is built in conjunction with Eaton Vance s team of institutional credit research analysts that engage in a rigorous analysis and ongoing monitoring of the bonds held within the account.

7 NOVEMBER 2015 TIMELY THINKING LIABILITY-DRIVEN INVESTING 7 About Eaton Vance Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today s most discerning investors. For more information, visit eatonvance.com.

8 NOVEMBER 2015 TIMELY THINKING LIABILITY-DRIVEN INVESTING 8 Disclosure This material is presented for information purposes only, is generic in nature, provides a general description of our services and strategies and is meant to promote further discussion. It is not to be construed as investment advice, a recommendation to purchase securities or adopt any particular investment strategy. Views and opinions expressed constitute judgments as of the date indicated and may change at any time without notice. Different views may be expressed based on different investment styles, objectives, opinions or philosophies. Each investor s portfolio is individually managed and may differ significantly from the information provided in terms of portfolio holdings, characteristics and performance. Readers should not assume that any services provided or investments in securities, markets and strategies described were or will be profitable. There are no guarantees concerning the achievement of investment objectives, allocations, target returns or other measurements. Not all of Eaton Vance s recommendations have been or will be profitable. Actual holdings and performance will vary for each client. The views and strategies described may not be suitable for all investors. This material may contain statements that are not historical facts, referred to as forward-looking statements. Any references to forecasts or future returns should not be construed as an estimate or promise of the results a client portfolio may achieve. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions. Past performance is no guarantee of future results. Investing entails risk and there can be no assurance that Eaton Vance, or its affiliates, will achieve profits or avoid incurring losses Eaton Vance Management Two International Place, Boston, MA eatonvance.com

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